Magazine

How Europe Is Revving Its Engine

February 20, 2005

By Laura D'Andrea Tyson The European Union recently announced a five-year agenda that is unabashedly pro-business -- with a focus on growth, job creation, and technological innovation. Jos? Manuel Barroso, the new, young president of the European Commission, was previously Prime Minister of Portugal, one of Europe's success stories. His zeal for fostering employment and a business-friendly environment is genuine. Under his leadership, the EC has pledged to subject all new regulatory initiatives to a tough competitiveness test before they are approved. After a decade of disappointing economic performance, is Europe poised for a sustained rebound? There are reasons to think so.

In fact, Europe's recent performance has not been nearly as dismal as many observers suppose. Excluding the 10 new members -- primarily former Soviet-bloc nations that joined the EU in May, 2004 -- output per hour worked in the EU is only slightly lower than in the U.S. According to a Conference Board study, productivity growth in the U.S. between 1995 and 2004 was one percentage point greater than in the EU (2.5% a year vs. 1.5%). But Austria, France, and Sweden were not far behind.

TO SOME EXTENT, European productivity growth has been the victim of the moderate success of another EU policy goal: increasing the employment participation rate. Since the EU population is growing at only about 0.2% per annum, economic growth hinges on providing jobs for the working-age population. EU employment participation has increased at 0.5% a year over the past decade, with most of the growth occurring in the past five years. In contrast, the U.S. rate has been falling at 1.2% per annum since 2000 in response to weak labor demand.

Labor-market reforms are promoting both labor-force participation and enhanced flexibility in the EU. Germany has introduced reforms that ease dismissal protection for workers and encourage the unemployed and low-skilled workers to take new jobs. In the short run, these reforms are likely to increase the unemployment rate in Germany. In January the number of unemployed topped 5 million, the highest figure in more than 50 years. But in the long run, such reforms are essential to reducing labor costs and labor-market rigidities. France is loosening some of the restrictions on working more than 35 hours per week and promoting youth employment through training and apprenticeships. Both temporary and part-time workers are growing as a share of total employment throughout the EU.

The enlargement of the EU to include 10 new members with lower labor costs is propelling changes within the richer nations. Several big German corporations have used credible threats of outsourcing work or moving production facilities to the new EU countries to win benefit cuts and an extension of working hours without additional compensation.

Many European companies have made massive investments in information and communications technologies (ICT) in recent years and are completing corporate restructuring plans to maximize returns on these investments. The strength of the euro is compelling European firms to focus on productivity while reducing the cost of additional investments in ICT equipment. As a result, Morgan Stanley economists are predicting that Europe may be at the beginning of a productivity revival like the one the U.S. has enjoyed from an earlier boom in ICT investment.

The most important thing the new European Commission can do to foster increased productivity is to accelerate product market deregulation, especially in such key sectors as telecom, financial services, retail, and business services. In the U.S., the most dramatic productivity gains from the ICT revolution have been realized in these intensive ICT-using services. But Europe still suffers from national regulatory regimes that pose barriers to the expansion of existing players and to the entry of new ones in the services sector. These barriers lie behind a jarring dichotomy in the EU between a modern, often highly competitive industrial sector and an underdeveloped, sometimes antiquated service sector.

In the past five years the EU has successfully absorbed 15 new member states and introduced the euro, which in turn bolstered intra-European trade and financial market integration. Now there are promising signs that Europe may be on the verge of a secular improvement in employment and productivity growth. That would be great news for the world economy.

Laura D'Andrea Tyson is dean of London Business School (ltyson@london.edu).